Stanford Academics Focus on Wrong Problems at ISS

In a recent Stanford “Closer Look” publication (How ISS Dictates Equity Plan Design), Ian D. Gow (Harvard but graduated from Stanford), David F. Larcker, Allan l. Mccall, and Brian Tayan argue ISS dictates pay equity plans. ‘Nonsense,’ was my first reaction. ISS policies generally reflect the will of its customers. The authors have a point but they miss the main problem. Their arguments begin in familiar territory.

First, institutional investors have little economic incentive to incur the research costs necessary to develop proprietary voting policies. In effect, proxy research suffers from a “free-rider” problem common to many voting situations. The average institutional investor owns a small fraction of a public company’s outstanding shares. While each investor bears the total cost of their research into proxy matters, the benefits of researching “correct” voting decisions are shared across all shareholders. As a result, the average institutional investor has little incentive to bear the costs of researching idiosyncratic firm issues across a diversified portfolio of investments when they only stand to receive a small fraction of the benefit.

Large funds, such as Vanguard, Northern Trust, BlackRock and Fidelity (see AFL-CIO Key Votes Survey Results for 2012) have little incentive to monitor their portfolios and take an active role in challenging management and boards. Since they hold diverse portfolios, any benefit they could obtain through such actions would equally benefit competitors, while they would bear all the costs (free rider problem).

That’s why Mark Latham developed the concept of a proxy advisor competition. Shareowners at Cisco will be the first to vote on a new version of such competitions that eliminate the free rider problem. All shareowners would have access to proxy advice from several contestants and the company would pay based on a vote by shareowners.

A second problem pointed out by the Stanford authors is that the SEC gave institutional investors an incentive to follow the recommendations of third-party advisory firms, rather than develop their own policies that might be deemed to be subject to conflicts. “As a result, the proxy voting guidelines of third-party firms have become a cost-effective means of satisfying fiduciary and regulatory voting obligations for institutional investors.” True, but as has already been discussed, most funds don’t have the incentive to do any substantive research on proxy issues and proxy advisors don’t develop their policies in a vacuum. They typically survey their clients and reflect those wishes back to them like a mirror. Of course, companies report those policies influence how they construct proxy issues, including pay plans, as they should. Shareowners will vote down policies and plans that stray far from their interests, so companies and boards would do well to heed them.

Another concern enters with ISS’ practice of sellingearly access to its methodology concerning how it will recommend on pay practices at individual companies through its subsidiary ISS Corporate Services and a product called Compass. Compass “allows corporate clients to input the details of a pending equity plan proposal into its model” and then determine the upper limits of equity grants that won’t trigger a “no” vote. According to the paper, “access costs between $23,500 and $29,500 per proxy filing, depending on company size. Further, among a sample of 4,230 company observations between 2004 and 2010, a full 34.1 percent (1,444) proposed equity plans that would put the company within 1 percent of their SVT cap.”

Of course, such odds cannot be explained by chance. I don’t see this as startling. ISS has a lot of customers who hold a disproportionate share of the market. If I am on the board of a public company it makes sense for me to look at their policies, try to figure out how they will recommend, and stay within those guidelines. I do see at least one point where I agree with the authors. Apparently, “firms are prohibited by the terms of the contract with ISS from disclosing to shareholders that they used Compass to determine their plan design.” That doesn’t seem right, although I’m not sure why it would make any difference to shareowners if they knew.

Near the end of the paper, the authors note that in October 2013, the NASDAQ OMX petitioned the SEC to require proxy advisors to publicly disclose their methodologies and conflicts of interest before institutional investors are allowed to rely on their policy guidelines to satisfy their fiduciary voting obligations. I understand the SEC’s Investor Advisory Committee is also looking at how, if at all, proxy advisors should be regulated.

Of course, these Stanford authors aren’t the only ones to be critical of ISS. The Business Roundtable and the U.S. Chamber of Commerce have been attacking them for years. Unlike the Stanford group or the business interests, CII doesn’t think shareowners are dictated to by ISS. However, their executive director Ann Yerger did testify to House Subcommittee on Capital Markets and Government Sponsored Enterprises in June that proxy advisors should “provide transparency into the general methodologies—without compromising proprietary models—used to make recommendations.”

In September, Nell Minow and Richard Koppes, speaking to 400 attendees at the Council of Institutional Investors conference in Chicago said proxy-voting advisory firms should spin off their businesses that advise companies on corporate governance to avoid the conflicts of interest of trying to serve two different sets of clients — institutional investors and corporations.

“It is idiotic” to have a business with such conflicts, said Nell Minow, a director at GMI Ratings, a firm whose focus includes corporate governance research and analytics. (Proxy advisory firms should split businesses — CII speakers, Pensions&Investments, September 27, 2013) I agree, ISS should sell off the part of its business that advises companies and should concentrate on its proxy services to investors. That would be the cleanest break to avoid any appearance of a conflict of interest.

Would that end the criticism? No. The real problem for many on the business side is that ISS is advising how to vote ‘say-on-pay.’ CEOs and many directors don’t like it. Many directors in Silicon Valley are so mad at ISS they refuse to serve on the boards of any company that doesn’t have a controlling owner, like Mark Zuckerberg’s control over Facebook. Their rationale is that ISS doesn’t know how to properly assess pay and has no business telling boards how much CEOs should be paid. (see SVNACD: Red Flags of an Ethical Collapse & Alternative Proxy Voting Advice to Stem Dual Class IPOs)

Granted, ISS must have a difficult time assessing pay and all the other proxy issues. Is that because they are evil? No, it is because their subscription business model doesn’t raise enough money so that they can devote the time necessary at each company to come up with better answers. Doing away with proxy advisors or cutting back on their resources will only make corporate governance worse. As per Gilson and Gordon, most large private funds don’t have an incentive to pay for better governance, so they won’t fill the gap.

The big problem is the free rider issue that Latham and I are trying to address by proposing a proxy competition at Cisco. Spend more, pay based on shareowner vote, make the advice available to all and increase competition. That’s how we could improve proxy advice. Of course, any system that constrains CEOs will still face major opposition. Cisco attacked our proxy proposal based on cost but they probably spent far more on attorney fees trying to win a no-action request at the SEC then they would be spending on the proposed proxy contest. Robert Monks, who along with Nell Minow, was the original founder of ISS, provided one of the best explanations as to why attacks will continue. See his informative post, Attacking Proxy Advisors.